In dealing with the trading and purchase of stocks through a brokerage, you may consider using margin. There is not a great mystery to using margin, it is simply borrowing other people’s money (usually, the brokerage’s). As always, when you consider borrowing money, there are good times to do it and bad times to do it. And as always, TANSTAAFL (There Ain’t No Such Thing As A Free Lunch).
You need always to keep in mind that a margin loan is accumulating interest every day; and if you look at the interest rates charged, especially in the smaller amounts, you will probably find them somewhat steep (nothing compared to what credit card rates are usually set at, but still…). Typically, the more money you borrow on margin, the lower the interest rate, but it is still a very real factor.
When you use margin, you are promising that you can pay the money borrowed back to the brokerage, by giving them the stocks in your account. If your account has 50,000 dollars worth of stocks, the brokerage may be willing to lend you (give you margin) of perhaps 40,000 dollars more. The brokerage would have a formula for this, and it would also depend on the quality (whatever that means to the brokerage) of the existing holdings.
If you borrowed the full amount allowed, and the value of your holdings dropped substantially, the brokerage might issue what is termed a margin call. They are simply asking you to pony up the cash so that the value of your stock holdings is more than what you have borrowed (however their formula works). If you have a lot borrowed, and the value of your stocks goes down dramatically, you can see the potential for disaster. Let’s look at some illustrations. Here we’re showing only gross generalizations.
In this example, there are a number of factors to consider. First, will the market in the particular securities you have purchased go up? How confident are you in your judgment of that factor? Second, how long will it take for the stock to go up? If it takes a year to go up 10 percent, and you are paying 10 percent margin interest, it doesn’t take a Fulbright scholar to see you haven’t really gained much. How about another example?
In this example, it looks like your sales proceeds of $18,000 isn’t too disastrous, but remember that $10,000 is borrowed (margin), and so has to be paid back. That’s why the value of holding at close is less than $8,000.
The above examples, of course, do not include any applicable fees, commissions, or charges, all of which would impact your profit or loss on your investments.
There are some advantages to using margin:
Competitive interest rates — Certainly compared to credit card rates, and perhaps many bank or credit union rates. It is also worth noting that margin is essentially a line of credit, and can be used for other purposes than buying securities.</li>
Repayment flexibility — There may be no set repayment schedule as long as the required level of equity is maintained in your account. Interest charges on outstanding balances are posted to your account monthly. Any cash dividends (not enrolled in dividend reinvestment) and interest received may be expected to be automatically applied to your margin balance.</li>
Convenience — As mentioned above, you may be able to borrow for any purpose, at any time. Once you have been approved for margin borrowing, there are no additional forms to complete, application fees to pay, or loan officers to consult.
As the tone of this discussion may imply, it is the opinion of this author that margin can be a useful tool when the market is in a fairly stable upward trend, and you are fully aware of the pitfalls of using margin. Most of the books mentioned in the Reference Library discuss the stable household as one that is not burdened with a lot of debt. Using margin debt should be done only when you are very confident (based on knowledge, not wishful thinking) that margin’s usefulness will clearly outweigh its costs. Caveat emptor!